David Gardner: When should you invest a lump sum?

In the geeky world of wealth managers, it's the equivalent of the electric blue horse statue you see upon entering Denver International Airport.

It provokes strong, divergent opinions that are rarely resolved to anyone's satisfaction. It also wades into the psychological side of money, which some analytical types may dismiss as irrelevant, but those of us who do this for a living understand as incredibly important.

The question is if you have a sizable amount of cash to invest, should you do it over time using dollar cost averaging (DCA) or in one lump sum?

All right, I know this is definitely a First World problem. But it's real.

An entrepreneur finally sold the company after years of toil. Mom died and now the house has been sold. A widow received a life insurance settlement and wants to use it wisely amidst her grief. An investor went to cash in during the winter of 2008 and now is wondering when to get back into the market.

Let's say you receive $100,000 in sudden wealth. You don't have credit card or other consumer debt and you want to invest it for the future. What are your options?

You could invest it all at once according to your target asset allocation. Let's say 60 percent stocks and 40 percent bonds is the best mix for your current financial status, time until retirement and spending goals. On day one you invest $60,000 in diversified stock mutual funds and the remainder in bonds.

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As an alternative, you could decide upon a period of months that you would like to gradually move your cash into investments. It could be done over three months, which would mean investing roughly $33,000 a month, or over 36 months.

By adopting a strategy of DCA over time, you are hoping to minimize the risk of your hardly won cash suffering through a sharp market downturn like we had four years ago. You want to avoid regret.

The academic literature is in broad agreement that you will, on average, end up with a higher return if you invest your funds all at once.

Vanguard published a study last year that examined the results of investing a $1 million windfall in the U.S., U.K., and Australia markets in a stock/bond portfolio with varying asset allocations and holding periods. The conclusion was that the lump sum investor prevails over the DCA investor about two-thirds of the time, looking at a 10-year time period of returns and using DCA over 12 months. As you lengthened the time you used DCA, the better the lump sum investor performed on a relative basis.

Truthfully this is an obvious conclusion. The stock market goes up most of the time, more than two-thirds of the years on average. It stands to reason that the sooner you invest cash, you will do better over time on average.

But most lump sum investors are concerned with the negative outliers: 2008 (-37 percent), 2002 (-22 percent) and 1974 (-27 percent). There's a chance we may be on the precipice again, you may think, so you sit on your cash.

While your risk is reduced with DCA, its less obvious advantage is behavioral.

By committing to go into the market over three to 12 months in equal portions, you will not be second guessing when the scheduled trading days arrive. Most likely you will be able to follow through on your plan. With a lump sum, you may find yourself tracking the ups and downs of market and waiting (and waiting) for that perfect moment to jump in.

It may not come for months or years, and then the odds of financial success are strongly against you.

David along with Timothy Watson, CPA, will give a lunch presentation on this year's tax changes to the Boulder Valley Rotary Club at noon Feb. 19 at the Spice of Life Event Center, 5706 Arapahoe Ave., in Boulder. Admission and lunch is $15 and you can RSVP through Facebook, meetup.com or bvrc.org.

David Gardner is a certified financial planner with a practice in Boulder County. He can be reached at yellowstonefinancial.com.

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